This week we’re going to try to explain third-party trust taxation. Unfortunately, the rules are not as straightforward or as simple. But that doesn’t mean you won’t understand them.

First, a quick definition of terms. A “third-party” special needs trust is one established by the person owning funds for the benefit of someone else — usually someone who is receiving public benefits. The usual purpose of such a trust is to allow the beneficiary to receive some assistance without forcing them to give up their Supplemental Security Income (SSI) or Medicaid (in Arizona, AHCCCS or ALTCS) benefits.

To figure out what to do about income taxes on the trust Jack set up, we need to consider a couple of questions:

Did Jack retain some levels of control over the trust while he’s still living?

If, for instance, Jack has the power to revoke the trust, or he stays as trustee, or even if he receives the trust’s assets back if Melanie dies before him, even this third-party trust may be a “grantor trust.” If it is, though, the grantor will be Jack — and he will probably pay any tax due on all of the trust’s taxable income. The trust will not need to have a separate EIN (tax number) and even if it does the actual income will usually be reported on Jack’s personal income tax return. None of the rest of this newsletter will be relevant to Jack’s income tax return.

What kinds of control might Jack have to trigger this treatment? There are volumes of suggestions and commentary written about that question, and it is impossible to answer without having spent some time reviewing the trust, its funding sources the IRS’s “grantor trust rules” and Jack’s intentions when he set it up. Some of the kinds of control might have been intentional, while others might surprise Jack (or even the lawyer who helped him draft the trust).

Does the trust treat principal and income differently?

Sometimes a trust might say that its income is available to the beneficiary, but not the principal (though this kind of arrangement is less common today than it was a few decades ago). In such a case the taxation of interest and dividends might be different from capital gains.

Does the trust require distribution of all income?

Some trusts mandate that the current beneficiary must be given all the trust’s income. That’s very rare in the case of special needs trusts (since the whole point is usually to prevent the beneficiary from having guaranteed income) but sometimes a trust might have been written before the beneficiary’s disability was known, and inappropriate provisions might still be included. If the trust does require distribution of income, it will be what the tax code calls a “simple” trust and will have some slight income tax benefit. But it also will probably need to be modified (if it can be) to eliminate the mandatory distribution language.

Has the trust made actual distributions for the benefit of the beneficiary?

It is a bit of an oversimplification, but usually trust distributions result in the beneficiary paying the tax due. That is true even though the distribution is not of income. Let us explain (but not before warning you that we are going to simplify the numbers and effect somewhat):

Assume for a moment that Jack’s trust for Melanie is not a grantor trust. It holds $250,000 of mutual fund investments, and last year the investments returned $20,000 of taxable income. During that year, the trustee paid $10,000 to Melanie’s school for activity fees (so that Melanie could participate in extracurricular activities, go on field trips, and have the services of a tutor). The trustee also received a $4,900 fee for the year.

Now it is time for the trust to file its federal income tax return (the Form 1041). The trust will report $20,000 of income, a $100 personal (trust) exemption, a $4,900 deduction for administrative expenses and a $10,000 deduction for distributions to Melanie. The trust will also send a form K-1 to Melanie showing the $10,000 distribution; she will be liable for the tax on the income. The trust’s taxable income: $5,000.

But what if the trustee also paid $15,000 for Melanie and her full-time attendant to spend a week at a famous theme park? As before, the trust will have a $5,000 deduction for the personal exemption plus administrative expenses, but distributions for Melanie’s benefit totaled $25,000 — and the remaining taxable income was only $15,000. The trust will report a $15,000 distribution of income to Melanie, and send her a K-1 with that figure. She will be liable for income taxes on the $15,000 and the trust will have no income tax liability at all.

We can come up with infinite variations on this story. Perhaps the trustee purchased a vehicle for Melanie, and had it titled in her name. Maybe there were payments for wages for that attendant. Each variation might change the precise nature of the deductions, reporting and taxation, but the bottom line will be (approximately) the same in each case. Distributions to Melanie or for her benefit will shift the taxation from the trust level to her individual return.

Is Melanie’s trust a “Qualified Disability Trust”?

Yes, it is. We slipped the controlling fact into our narrative quite a while back. Melanie receives SSI. The same would be true if she was receiving Social Security Disability Insurance (SSDI) payments. It could be true even if she was not receiving either benefit, but it probably would not be.

The effect of being a Qualified Disability Trust: instead of a $100 exemption (deduction) from trust income on the trust’s own tax return, the trust would get an exemption set at the current annual exemption amount for individuals. In 2015 that means the trust would get a $4,000 exemption — which could ultimately save the trust, or Melanie, the tax on that larger amount.

Some people resist understanding tax issues, thinking they are just too hard. We don’t agree. These concepts are manageable. We hope this helped.

We often find ourselves reassuring clients that the law makes sense. It may not be obvious or intuitive, but we can usually explain why some legal principle developed the way it did, and why it would be a bad thing if it were otherwise — even if that might mean problems for a given case in which we are involved. Once in a while, though, the system is just arbitrary, foolish and misguided. What really hurts is when a judge declares that an arbitrary corner of the law should be that way because it is not arbitrary.

Case in point (literally): Sandi Dowling (not her real name), a 26-year-old woman living in South Dakota. Sandi was in a terrible auto accident in 2006, when she was 19. As a result of a traumatic brain injury suffered in that accident, Sandi qualified for Supplemental Security Income (SSI) and her state’s Medicaid program. She also filed a civil lawsuit, seeking to recover at least some of the costs of her care, pain, suffering and future lost income.

Sandi gave her parents a power of attorney so that they could handle her lawsuit and any other financial issues she might face. So far, there is nothing in Sandi’s story that would not be faced by thousands of other young people injured in an auto accident.

Then Sandi’s lawsuit was settled. She netted $429,259.41 from the settlement — a sum which would normally knock her off SSI and probably cost her Medicaid eligibility, as well. That amount, though large, was not enough to provide the care Sandi actually needed, however, and so it was important for her to continue to qualify for SSI and Medicaid.

Fortunately, there is a way to do that. A self-settled special needs trust can be set up for someone in Sandi’s circumstance, and the money transferred to it. The transfer is not disqualifying, and the contents of the trust are not counted as available for SSI or Medicaid eligibility purposes. But the trust has to be set up properly.

One key rule about such trusts: they must be established by a parent, grandparent, guardian or court. Fortunately, Sandi’s parents were both deeply involved in her life and her care; they could sign the trust documents, and they did. They established the trust and, using their power of attorney, transferred her settlement proceeds to the trust’s name.

Imagine their surprise when the Social Security Administration ruled that the trust disqualified Sandi from SSI benefits. The eligibility worker, relying on directives from the SSA central office, ruled that when her parents established Sandi’s trust they weren’t her parents — they were her agents under the power of attorney. Her SSI was cut off (and, presumably, her Medicaid eligibility as well) and she was ordered to repay Social Security the money she had received since her personal injury settlement arrived.

Two years of legal wrangling ensued, with the Social Security Administration insisting that it makes sense to rule that Sandi’s parents weren’t her parents when they signed the trust. An Administrative Law Judge did (graciously) rule that she did not have to repay the money she had received before the family received notice of the overpayment, but the denial of eligibility persisted.

Finally, in an attempt to resolve the impasse, Sandi and her parents turned to the local courts. They sought and obtained a court order approving the trust and amending it in some technical ways; the judge also ruled that the modification of the trust should date back to the original trust date (what is called “nunc pro tunc” in lawyer-talk). Problem solved, right?

Not at all. The Social Security Administration, continuing to apply its rules rather than the English language, ruled that the court had not “established” the trust, but only “approved” it. Two more years of legal wrangling ensued, with the Social Security Administration insisting that this interpretation of language also made sense.

Eventually Sandi and her parents exhausted their appeals through the Social Security Administration, and they finally turned to the Federal District Court in South Dakota. They filed an appeal of the final Social Security ruling, and argued that it was arbitrary and capricious of Social Security to insist that (a) Sandi’s parents weren’t her parents when they signed the trust and (b) the local court had not “established” the trust but only “approved” it. Finally, they thought, they were going to get a decision from someone who would apply some common sense rather than absurd rule interpretations.

There’s still no joy in Madison. District Judge Karen E. Schreier upheld the Social Security position, finding that its interpretation of the language of the federal statute was not arbitrary. In fact, she held, having clear rules is the opposite of arbitrary — never mind that the clear rules are silly. Draper v. Colvin, July 10, 2013.

What are the lessons to be learned from Sandi’s story, and why are we telling you about it? Normally we do not report on trial court decisions here — and even though this is an appeal from a Social Security ruling, it is the lowest level of the federal court review of that ruling. It might well be appealed; in the meantime, it should not be cited as precedent in other cases (and especially in other jurisdictions, like the Federal District Courts in Arizona). But it still gives us pause and an opportunity to point out several important principles:

Creating (“establishing,” in the language of the federal statute) special needs trusts can be difficult to do correctly, and technical rules have to be followed.

Though it may seem obvious that something ought to be done in an efficient, effective and legal way, sometimes the requirements are actually counter-intuitive, or are interpreted in a counter-intuitive way.

The Social Security Administration (and, often, state Medicaid agencies) are always on the lookout for ways to challenge special needs trusts.

Doing things wrong not only causes problems with government programs, but is hard to fix. Witness Sandi’s odyssey, with four years of litigation and multiple attempts to satisfy Social Security’s arcane rules — all the while with Sandi not qualifying for or receiving SSI until first the agency and then the courts work through their interpretations.

Even when a fix is finally found, it likely will not relate back to the original date of the problem. Legal expertise is important early and throughout the administration of a special needs trust.

Much of the court opinion in Sandi’s case deals with the language of the POMS — Social Security’s “Program Operations Manual System.” That’s where the worst language offenders live, and it is crucial for practitioners to be familiar with the structure, holdings and, yes, silliness built into the POMS.

“When in doubt about who’s to blame,” Craig Ferguson is reported to have said, “blame the English.” We aren’t sure he meant the language, but still it seems apt.

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JANUARY 16, 2012 VOLUME 19 NUMBER 3
Let’s say you have a child with “special needs,” or a sister, brother, mother or other family member. You have not created a special needs trust as part of your own estate plan. Why not?

We know why not. We have heard pretty much all the explanations and excuses. Here are a few, and some thoughts we would like you to consider:

I don’t have enough money to need a special needs trust. Really? You don’t have $2,000? Because that’s all you have to leave to your child outside a special needs trust to mess with their SSI and Medicaid eligibility.

I can’t afford to pay for the special needs trust. We apologize that it can be expensive to get good legal help. But the cost of preparing a special needs trust for your child is likely to be way, way less than the cost of providing a couple month’s worth of care. That is what is likely to happen if you die without having created a special needs trust, since it will take several months of legal maneuvering to get an alternative plan in place. Even if there is no loss of benefits, the cost of fixing the problem after your death will be several times that of getting a good plan in place now.

I’ve already named my child as beneficiary on my life insurance/retirement account/annuity. Ah, yes — our favorite alternative to good planning. If your child is named directly as beneficiary, you may have avoided probate but complicated the eligibility picture. Their loss of benefits will occur immediately on your death, rather than waiting the month or two it would have taken to get the probate process underway. This just might be the worst plan of all.

It’ll all be found money to my kids. I’ll let them take care of it if I die. We have bad news for you: “if” is not the right word here. That aside, you should understand that a failure to plan means you are stuck with what’s called the law of “intestate succession.” That means (in Arizona — if you are not in Arizona you might want to look up your state’s law) that if you die without completing your estate plan, your spouse gets everything unless you have children who are not also your spouse’s children. If you are single, your kids get everything equally. If your child on public benefits gets an equal share of your estate, we will probably need to either (a) spend it all quickly or (b) put it into a “self-settled” special needs trust. That means more restrictions on what it can be used for, and a mandatory provision that the trust pays back their Medicaid costs when they die. All their Medicaid costs. Including anything Medicaid has provided before your death. Wouldn’t you like to avoid that result? It’s simple: just see us (or your lawyer if that’s not us) about a “third-party” special needs trust. The rules are so much more flexible if you plan in advance.

My child gets Social Security Disability (or Dependent Adult Child) Benefits and Medicare. Good argument. Because those programs are not sensitive to assets or income, your child might not need a special needs trust as much as a child who received Supplemental Security Income (SSI) and Medicaid (or AHCCCS or ALTCS, in Arizona). But keep these three things in mind:

Even someone who gets most of their benefits from SSD and Medicare might qualify for some Medicaid benefits, like premium assistance and subsidies for deductibles and co-payments. Failure to set up a special needs trust might affect them, even if not as much as another person who receives, say, SSI and Medicaid.

Even someone receiving Medicare will have some effect from having a higher income. Premium payments are already sensitive to income, and future changes in both Medicare and Social Security might result in reduced benefits for someone who has assets or income outside a special needs trust.

If your child has a disability, it might be that a trust is needed in order to provide management of the inheritance you leave them. If they are unable to manage money themselves the alternative is a court-controlled conservatorship (or, in some states, guardianship). That can be expensive and constraining.

I’m young. We agree. And we agree that it’s not too likely that you will die in the next, say, five years (that’s about the useful life of your estate plan, though your special needs trust will probably be fine for longer than that). But “not too likely” is not the same as “it can’t happen.” You cut down your salt and calories because your doctor told you it’d be a good idea — even though your high blood pressure isn’t too likely to kill you in the next five years, either. We’re here to tell you that it’s time to address the need for a special needs trust.

I’m going to disinherit my child who receives public benefits and leave everything to his older brother. That will probably work. “Probably” is the key word here. Is his older brother married? Does he drive a car? Is he independently wealthy? These questions are important because leaving everything to your older child means you are subjecting the entire inheritance to his spouse, creditors, and whims. And have you thought out what will happen if he dies before his brother, leaving your entire inheritance to his wife or kids? Will they feel the same obligation to take care of your vulnerable child that he does?

I’ll get to it. Soon. OK — when?

I don’t like lawyers. We do understand this objection. Some days we’re not too fond of them, either. But they are in a long list of people we’d rather not have to deal with but do: doctors, auto mechanics, veternarians, pest control people, parking monitors. Some days we think the only other human being we really like is our barista. We understand, though, that if we avoid our doctor when we are sick the result will not be positive. Same for the auto mechanic when our car needs attention. Also for the vet and all the rest. In fact, the only one we probably could avoid altogether is the barista, and we refuse to stay away on principle.

Seriously — lawyers are like other professionals. We listen to your needs, desires and information, and we give you our best advice about what you should do (and how we can help). Most of us really like people. In fact, all of us at Fleming & Curti, PLC, really like people — it’s a job requirement. We want to help, and we have some specialized expertise that we can use to assist you. Give us a chance to show you that is true.

FEBRUARY 6, 2011 VOLUME 18 NUMBER 5
What can a parent do to ensure continuing care for his or her adult child with a disability? That was the dilemma facing Californian Earl Blacksher in the late 1980s. His daughter Ida McQueen lived with him in the family home in Oakland. She was developmentally disabled, and she received Supplemental Security Income (SSI) payments; she had no other resources and Mr. Blacksher’s own assets were largely limited to the home.

Mr. Blacksher signed a will. He directed that Ms. McQueen be allowed to live in the house for the rest of her life, and that the rest of his small estate be placed in trust to help her pay for the care and services that would be required to let her stay at home. He left his two brothers in charge of the estate and the testamentary trust he created.

After the brothers restructured the mortgage on the house, Ms. McQueen could live there on her SSI payments — just barely. When she became ill a decade later she moved temporarily to a nursing facility. With no resources to help pay for in-home care, and with escalating needs, she could not return to the home.

The attorney who had handled the probate in the first place had never been paid, since there was not enough money to take care of her bill. Neither had the brothers been paid for their work in handling the estate. Nor had the real property taxes on the home been kept current. It appeared that there was no choice but to sell the house, pay bills, and distribute any proceeds. The attorney assisted the trustee in listing and selling the house.

After all the bills were caught up there was $90,000 left to distribute. The attorney, apparently reasoning that Ms. McQueen had effectively abandoned her life estate interest in the home by failing to pay taxes and keep payments current, decided that nothing needed to be retained in Mr. Blacksher’s trust, and she arranged distribution of the proceeds to the remaining family members.

Almost immediately a conservatorship was begun to investigate the transaction, and a lawsuit was filed against several family members and the attorney who had arranged the sale and distribution. The lawsuit argued that the net proceeds should have been retained in trust for the benefit of Ms. McQueen. In response, the defendants insisted that it was reasonable to treat Ms. McQueen’s right to use of the house (or proceeds from its sale) as terminated, and that in any event any money she would have received would have simply interrupted her eligibility to receive SSI payments and subsidized care from California’s Medicaid program.

At trial two attorneys testified about the possibility of treating Mr. Blacksher’s trust as a “special needs” trust, which might have allowed Ms. McQueen to have the benefit of the sale proceeds without losing her eligibility for SSI and Medicaid. One expert opined that the option should have been discussed; the other pointed out that Mr. Blacksher’s trust did not qualify as written, and that California law would not have permitted a revision. Ultimately, however, the language of Mr. Blacksher’s testamentary trust was irrelevant — the trial judge precluded testimony about SSI benefits, and the jury found that most of the defendants had participated in taking money from Ms. McQueen. They were ordered to return $99,900 to Ms. McQueen.

One defendant — the attorney — was singled out by the jury for additional penalties. She was the only one the jury found liable for elder abuse, a separate claim under California law (and, incidentally, under the law of Arizona and most, if not all, other states). That did not directly increase the jury’s award against her, but it did have a significant additional effect. California law permits an award of attorneys fees against a party found liable for elder abuse. The attorney was ordered to pay Ms. McQueen’s lawyer’s fees, which totaled another $320,748.25.

The California Court of Appeal considered several arguments but ultimately upheld the judgment, including the effectively quadrupled award against the attorney. Key to the appellate court’s ruling was a finding that it was irrelevant whether Ms. McQueen received SSI or Medicaid benefits, or whether she would have lost those benefits if the terms of her father’s trust had been carried out as written. The judges were also unimpressed by an argument that the attorney acted reasonably in deciding, albeit wrongly, that failure to pay taxes or upkeep on the house effectively ended Ms. McQueen’s interest in the trust. McQueen v. Drumgoole, January 14, 2011.

The litigation involving Mr. Blacksher’s testamentary trust proves what every parent of a child with disabilities already knows: it can be very difficult to come up with a plan that adequately protects your child after your death. Mr. Blacksher’s trust may have been inadequate to the task, but it may be that the basic inadequacy was in the plan itself — there does not seem to have been enough money available to let Ms. McQueen stay in the family home after his death.

What might Mr. Blacksher have done differently? It is hard to be certain on the sparse record in the Court of Appeal, but there are a number of planning questions we might have asked Mr. Blacksher if we had a chance to speak with him before he signed his will, including:

Does the testamentary trust language in your will adequately protect your daughter’s interest in the family home if it has to be sold? It appears that Mr. Blacksher’s will may not have done so — the trust he established may not have been a “special needs” trust.

Do you have a realistic plan about how your daughter’s care can be provided? It appears from the outcome that there were not sufficient assets available to provide in-home care, even if health problems had not intervened to send Ms. McQueen to a care facility.

If a move from the home is inevitable after your death, have you given adequate consideration to alternatives now? Might it be best to look into transitioning your daughter into a suitable placement while you are still able to participate in the selection and oversight of the care home?

How involved — both in terms of time and in financial and other support — will the rest of the family be in caring for your daughter? Most parents recognize the high personal cost of providing full-time care. Did Mr. Blacksher’s family members realize that they would need to provide some of that care after he was unavailable, or did they realize it but lack the resources to do what he had done for years?

For lawyers, the key messages from the McQueen v. Drumgoole case are probably:

The “collateral source” rule, which prevents jury consideration of other payments available to the plaintiff in most civil lawsuits, applies in a case like this to prevent discussion of the SSI and Medicaid benefits a plaintiff might be entitled to receive — even if a successful verdict might eliminate those benefits.

The attorneys fees generated in complex litigation might all be chargeable against an unsuccessful defendant, even if not all of the claims (and all of the defendants) are found liable for any attorneys fee award.

For family members, though, the takeaway message is simpler:

Failure to plan realistically for your child’s care may result in a failed care plan.

JANUARY 31, 2011 VOLUME 18 NUMBER 4
One question we are frequently asked: isn’t it a good idea to set aside money for a child or grandchild, and isn’t a UTMA (Uniform Transfers to Minors Act) account a simple way to do that? OK — that’s really two questions. Our answers: Yes, it is a good idea to set aside money. Yes, the UTMA account is a simple way to do it. Don’t set up a UTMA account, however, until you understand the consequences.

There are confusing issues about UTMA accounts. Sometimes the confusion is heightened by the fact that each of the 48 states which have adopted versions of the UTMA Act has changed it a little bit — so what is true in Arizona may not be true in another state (and vice versa). Rather than indulge in all that confusion, however, we are going to tell you in straightforward language what to watch for in Arizona. Be careful about applying these principles to other states’ UTMA acts.

They are inexpensive to set up and to administer. They do not require a lawyer, and avoid courts and formal accounting requirements altogether. All you have to do to create an Arizona UTMA account is to include the name of a custodian, the name of the beneficiary, and the letters UTMA in the title. This will work: “John Jones as custodian pursuant to the Arizona UTMA for the benefit of Marie Smith.”

A UTMA account can simplify the gifting of substantial amounts of money by multiple family members. Set up an account for your 2-year-old, and all four grandparents can put $13,000 each into the account each year (using 2011 numbers — the maximum non-taxable gift may go up next year or in future years).

They automatically end at 21, so the money will not be tied up indefinitely. One of the points of confusion: sometimes UTMA accounts end at 18 in other states, and in some circumstances in Arizona. But if you are putting your money into an account for a minor in Arizona, the end date is age 21.

They encourage regular savings by simplifying the process. Open an account with, say, $1,000, and put $50/month into the account. You won’t save a fortune in 15 years, but you will have $10,000 that you wouldn’t otherwise have saved without this discipline. Plus the earnings and growth on the investment, as a bonus.

If the minor receives public benefits like SSI or Medicaid, the money will usually not be treated as “available” (and therefore reduce or eliminate benefits) until age 21.

Of course it’s not all good news. Here are some problems or limitations:

The money in the UTMA account will need to be reported on the minor’s FAFSA (Free Application for Federal Student Aid) form when applying for student aid — and it will be treated as completely available to the student. In other words, the very existence of a UTMA account may prevent receipt of needs-based student aid.

The income in the UTMA will be taxed at the minor’s parents’ income tax rates. Unless, of course, there is so much money in the minor’s name that his or her rate is higher — then the UTMA account will be taxed at that higher rate.

The minor may have to file an income tax return if the UTMA money produces significant income. The UTMA account may be used to pay any income tax due, and the tax preparation costs, but it will require that a return be prepared.

At age 21 the (former) minor is entitled to receive all the money. Period. It doesn’t matter if he or she has become a drug addict, a spendthrift or a cult member.

If the (former) minor receives public benefits like SSI or Medicaid, at age 21 the UTMA account becomes an “available” resource and may compromise those benefits.

If the UTMA custodian is the parent of the minor (which is by far the most common arrangement), then there may be additional complications in how the money can be used and/or what tax effect the money might have. Since a parent has an obligation to support his or her minor children, the UTMA account generally can not be used by a parent/custodian in ways that reduce or satisfy that support obligation. If, on the other hand, the donor of the money acts as custodian, he or she may not have gotten the money out of his or her estate (which is usually one intention on the donor’s part).

Although UTMA accounts are usually seen as simple mechanisms avoiding lawyers and conflict, the custodian still has an obligation to give the minor (or his or her guardian) account information. Thinking of giving a divorced and non-custodial parent money for the benefit of his or her minor child? Know that you are inviting a dispute between the custodial parent and the UTMA custodian over how the money is invested and spent (or not spent).

What happens if the custodian dies or becomes incapacitated? There is no easy mechanism to select a successor custodian; it may require a court proceeding to name a successor. A fourteen-year-old minor may be able to select his or her own custodian, which could raise concerns for a thoughtful donor. (Note: Arizona law does allow the current custodian to name his or her own successor custodian, but few do. If you are planning on setting up a UTMA account, insist that the custodian select a successor.)

What happens if the beneficiary dies before reaching age 21? The money goes to his or her estate — which may require a probate proceeding (if the total is over $50,000 in Arizona) and usually means that the money will be split between the child’s parents. That may be fine, but it may not be what the donor intends or wants.

The effect of interstate proceedings is unclear. If you live in New Mexico and set up a UTMA account in an Arizona bank with an Arizona custodian for a minor who lives in Iowa, what happens when your custodian moves to Wisconsin? What courts might the custodian have to answer to, and whose law applies in the case of a disagreement? Fortunately, this problem seldom arises — there are few legal proceedings involving UTMA disputes. But they do happen, and increasingly so in an increasingly mobile society.

What are your alternatives to a UTMA account? Consider 529 plans for educational purposes, and separate trusts if the money is intended to be for more general use. For a child who earns income an IRA might even be an appropriate choice — if the child earns $3,000 in a given year, he or she can contribute up that amount to an IRA (and the source of the money does not have to be the earnings). Talk to your financial adviser and your lawyer about the cost of the various options, the problems they raise, and the best alternative in your circumstances.

SEPTEMBER 27, 2010 VOLUME 17 NUMBER 30
This is so confusing to clients, but it needn’t be. The rules are actually simpler than they seem. Stay with us, and we’ll walk you through it.

OK, here’s the set-up: You have three children, one of whom (the youngest) has a disability. We’ve decided to name her Cindy (sorry if we got that part wrong). Your estate plan is to leave everything equally to your three children, but you know that (1) Cindy can’t manage money, and (2) even if she could, leaving her money directly would knock her off of her public benefits. Just to make things more complicated, nearly half of your net worth is held in an IRA.

Before we roll up our sleeves, let us make a few observations about your situation:

If instead of an IRA you have a 401k, a 403b, Keogh or other retirement plan, the rules are pretty much the same. They’re somewhat different if you have a Roth IRA; we may tackle that issue in a future newsletter.

If Cindy’s disability entitles her to public benefits but she is able to manage money just fine then some of the trust issues might be different from what we describe here.

We’ve decided that your estate (your combined estate, if you are married) is just under the estate tax limits, whatever they might be. That’s so we don’t have to complicate this explanation with an estate tax element. But the truth is, that wouldn’t complicate things all that much — we just don’t want to have to throw those oranges into our apple basket. Not today, anyway.

Ready? Here we go. We’ll start by asking you some questions:

First question: What benefits does Cindy get? Is she on Supplemental Security Income (SSI)? Does she also get Social Security benefits, either on her own work history or on yours? Is she receiving Medicare coverage? How about Medicaid (or, in Arizona, AHCCCS)? Does she also get a housing subsidy, benefits through the Division of Developmental Disabilities, or therapy and care from the school district?

This question is important, because first we need to figure out whether her benefits will be affected by any trust you might set up for her. Here’s a surprise: it’s not enough to figure out what benefits she is on now, particularly if she was disabled before age 22. She might be eligible to receive benefits on your work history (or your spouse’s), and those benefits could go up when you retire and again when you die. Since your estate plan is all about what happens to your money when you die, the benefits Cindy gets then will be more important than the benefits she receives now.

Second question: How important is it to you to give your children the chance to “stretch-out” your IRA? We’re sorry — we didn’t explain what that means.

You already know that you have to withdraw money at a set pace, calculated based on your life expectancy, once you reach age 71 (we know — it’s really 70.5; it’s actually the year after you turn 70.5, so let’s just call it 71, okay?). You probably also realize that your beneficiaries get to use their own life expectancies after they inherit your IRA. Or at least they do most of the time.

If that is important to you, your beneficiary designation should make it easy for your children to use the longest stretch-out period possible. Since they are probably all different ages that means there is a benefit — maybe a slight one, but a benefit — to the youngest children to be able to use their own age rather than being stuck with an older sibling’s age.

Note: this assumes your children share your interest in stretching out the IRA withdrawals. Take the simple case, with Cindy not involved: if you make the other two children (let’s call them Amelia and Barbara) beneficiaries of the IRA, Barbara (the younger) will be able to take a little less out each year than Amelia is required to do. But if either of them decides to just withdraw all the money and use it for an extended European vacation, then they can choose to make a decision that is not tax-wise. If you want to prevent them from doing that, you have raised the complication factor — but it can be done. We’re just not going to try to explain it here. But we do — here.

Third question: Do you want to try to give Cindy some non-IRA assets rather than an interest in the IRA, just to make this simple? Let’s say you left your IRA to Amelia and Barbara, and increased Cindy’s share of the non-IRA assets to make the shares equal. Would that work?

Well, yes — but it’s not quite that easy. Say you leave $100,000 in an IRA to Amelia — is that worth $100,000 to her? No, because she will have to pay taxes on it when she takes it out. How much? It depends on her state, her marginal tax rate and how long she leaves it in the IRA, so it’s very hard to figure out the “real” value to Amelia. Plus we know that the real value of the same amount of IRA will be different for Barbara, making the calculation that much more difficult.

Maybe we can use a rule of thumb, though. Let’s guess that Amelia and Barbara will delay taking out their inherited IRA money as long as possible, and that when they do they’ll both be retired and not making a lot of income. Perhaps the “real” value (to them) of your IRA will be 65% to 80% of its balance when you die. Is that close enough for you to figure out what would be “fair” if you gave Cindy more cash and less IRA? We can’t tell you — this one is a judgment call for you.

Fourth question: Who will manage Cindy’s money after your death? Amelia, the banker (and classic first-born)? Barbara, who has some financial challenges of her own but has always been close to Cindy, and still lives in the same community with her? Your local bank? A family friend, or a professional you have worked with?

Enough questions for a moment. Let us tell you what we think, based on your answers.

First, you can create a trust and name it as beneficiary of your IRA. Don’t listen to your banker or your accountant if they tell you that you can not do that — they are reciting old rules that no longer apply.

But if you do name a trust as beneficiary, you are likely to force everyone to use a shorter stretch-out date — probably all three daughters will be stuck with Amelia’s life expectancy. If there are only a few years’ difference between the girls, that may not be a big deal. If this issue is important, then we probably can work around it — we can name Amelia and Barbara as beneficiaries directly, and a stand-alone “special needs” trust for Cindy’s benefit to receive her share of the IRA. If we do that, though, you have to make us a promise: you can’t let anyone else tell you to change your beneficiary designations after we get them set up. At least you have to promise not to make any changes until after you have met with us and gone back over the beneficiary form.

In fact, you will find that you have to help educate lots of folks about IRA beneficiary designations. Over time you will be told that you have a mistake in your designation, that you have unnecessarily caused tax increases for your daughters, that your lawyer obviously doesn’t know how to do this. We do, and we can help you respond to those bankers, accountants and others who tell you that you need to make changes. Keep us in the loop, please.

We also need to make sure you realize Cindy’s share can’t go to charity after her death. None of it. Even though the non-profit which provides a sheltered workshop for her would be the logical beneficiary of a share of “her” IRA portion, it mucks everything else up.

So how do we get Cindy’s portion of the IRA — and for that matter the rest of her inheritance — set up to benefit her without knocking her off of her SSI, Medicaid, AHCCCS and other government benefits? That’s what a special needs trust is all about.

We have important advice for you: Be careful as you look for information about special needs trusts, though: much of what you read will be about the rules (and limitations) on so-called “self-settled” special needs trusts, and Cindy’s trust will not be one of those. You will be establishing a “third-party” special needs trust, and the rules will be much different, and much more liberal. You can leave IRA and non-IRA assets in a special needs trust for Cindy’s benefit, and you will actually improve the quality of her life without jeopardizing the programs and benefits she receives.

We hope this helps sort through some of the finer points of IRA beneficiary designations. If you want more, we can recommend a really thorough article by our friend Ed Wilcenski, a New York lawyer. He wrote for Forbes.com, and he’s a smart guy who writes well.

Incidentally, we’d love to hear from you. Maybe you have a question about IRAs and special needs trusts, or you just want to tell us whether this helped you out. Maybe you want to quibble with some of our advice. We love to hear from readers.

We will not, however, undertake to represent you based on a simple e-mail or internet inquiry — we need much more information (starting with where you live — we don’t practice outside Arizona) before undertaking a lawyer/client relationship. We won’t be able to answer your specific questions about your own legal situation, either. What good are we, then? Well, we’ll try to demystify some of the general rules and answer general questions about these topics. Contact us if you’d like us to try, or simply Leave a Reply below. We’ll read your comments and let you know, even if we can’t help you with individual legal problems.

Most people are familiar with modern concepts of child support. It can be awarded to the custodial parent in a divorce proceeding. The amount of support is usually calculated by reference to standardized computations promulgated by the courts. A support award usually includes an automatic assignment of wages to help ensure the payments get made. It ends when the child reaches age 18. Wait — that last one is not necessarily correct.

Most states (Arizona included) permit courts to order continued child support for an adult child with a serious mental or physical disability. The rules vary from state to state, but Arizona’s approach is not particularly unusual. If you are concerned about this issue because you know about an adult child with a disability living in another state, be sure to check that state’s laws before assuming the Arizona rules are identical.

In Arizona, child support can be awarded to an adult child with a disability if:

The child is severely disabled, either mentally or physically, and is “unable to live independently and be self-supporting,”

The disability began before the child turned eighteen, and

The court considers the financial resources and needs of the child and both parents, along with the effect of the disability on those needs.

[There are actually two circumstances in which child support can extend past age 18 under Arizona law. The court can also continue child support until age 19 if the child is still in high school.]

See Arizona Revised Statutes section 25-320(E) for the precise language of Arizona law. Note that the law does not require the parents to be divorced, separated or even pending divorce or separation. A court proceeding can be initiated solely for the purposes of establishing support requirements, and the resulting order can be directed against either or both parents — including against a parent with whom the adult child lives. Note also that the support request does not have to be filed before the child reaches age 18, though the disability itself must begin before that age.

A recent Arizona Court of Appeals case dealt with the issue of support for an adult disabled child. In Gersten v. Gersten, decided November 17, 2009, the appellate court dealt with a trial court decision denying support payments to the father of an adult child with a disability only because the father had not been appointed as his son’s guardian or conservator. The Court of Appeals directed that the matter be returned to the trial court, and the son’s interests considered either by having a guardian or conservator appointed or by joining him as an actual party to the divorce proceedings.

One common problem when support is ordered paid to an adult child with a disability (or to the parent with whom the child lives): the support will be treated as income for Supplemental Security Income (SSI) eligibility purposes. See, for example, the Social Security Administration’s POMS section SI 00830.420(C), which sets out the procedure an SSI eligibility worker must follow when assessing child support payments for an adult child with a disability.

That may mean that the support order reduces the beneficiary’s check by almost as much as the support order, and it might even result in elimination of SSI. That, in turn, might lead to the loss of Medicaid benefits paid for through the Arizona Health Care Cost Containment System (AHCCCS).

In some cases it might be possible to maintain eligibility for public benefits and still seek an award of support for the benefit of an adult child with a disability. A special needs trust for the benefit of the child support recipient can be set up (perhaps even by the court ordering the support) and the monthly payments assigned to the trust. The process is not always simple or straightforward, and an experienced attorney should be consulted.

If your child has a disability you will have thought about what would happen on your death. Who will take care of your child? Who will pay for that care? Your estate plan can help address those concerns—and should probably include what most in the disability community call a “special needs” trust.

Government benefits can be crucial to the welfare of a child with disabilities. Supplemental Security Income (SSI), Medicaid (in Arizona, AHCCCS or ALTCS), Title XIX and Section 8 housing benefits—each program has its own eligibility rules, but most require that the recipient not have significant assets or income.

Some parents choose to simply disinherit a child with disabilities—not because they love the child any less, but because they fear the loss of those government benefits. At the same time, reliance on government programs leaves parents concerned about who can provide the personal oversight and involvement they bring to their child’s care while they are still able to do so.

Parents of children with disabilities should always consider establishing a trust for the child. A properly drafted trust can help supplement the minimum benefits provided by government programs, without displacing those programs altogether. In this way the parents’ assets can enhance their child’s life without being consumed by the high cost of care.

A special needs trust can provide funds for case management, advocacy, supplemental medical and dental care, therapies not covered by government benefits, companions and other care for the child with disabilities. It can also pay for education, travel, entertainment, visits from (or to) siblings, furniture, adaptive aids and other items that improve the quality of the child’s life.

The central rules governing a special needs trust are that payments should not be made for necessities such as food, clothing or shelter, and that cash distributions are usually not permitted. A carefully drafted trust can, however, permit the trustee to make even those disbursements at least on an occasional basis, and recognizing that there may be a temporary effect on government benefits programs.

One problem that remains is for the parents to select a suitable trustee. Siblings may be the best choice to handle the funds, though they will need special training in what kinds of investments and expenditures they should authorize.

Of course the same principles apply when the person with disabilities is not your child but a grandchild, niece, nephew or simply a family friend. It is essential in all such cases that any inheritance left to anyone who now receives or might later be eligible for government benefits be properly protected. The same can be said for life insurance and retirement benefits, as well.

At Fleming & Curti, PLC, we prepare special needs trusts for our Arizona clients. We also provide assistance and advice to trustees, so that they can protect government benefits while encouraging the independence and autonomy of beneficiaries with disabilities. We regularly counsel parents of children with disabilities, whether they currently receive government benefits or want to protect the possibility of future program eligibility.

For more information about the subject look at our Legal Q&A section on Special Needs Trusts. The Special Needs Alliance, a national affiliation of lawyers with expertise in special needs planning, also maintains a website with useful information and links to practitioners in nearly every state.